Linear Technology: Love the Story, But Not the Price

You can fill a lot of pages with what is right about Linear Technology (NASDAQ: LLTC  ) . Not only is Linear among the leaders in the analog chip space, but it has a long history of excellent profitability. In fact, profitability is so important to the company that it let go of Apple's business when the margins no longer met management's standards.

Looking ahead, there's real growth potential for Linear in the industrial and auto markets in the coming years. Linear isn't the only company prioritizing these markets, as ON Semiconductor Analog Devices, and Texas Instruments are there too, but the potential of grabbing a larger share of auto OEM content and leveraging the Dust acquisition in factory automation is compelling. Alas, the price is not so compelling and investors need to really be sure that Linear is going to continue topping estimates for the stock to work at this price level.

A quarter pretty much as expected
Linear reported almost 10% year-over-year revenue growth this quarter, although sales were down 2% by the more-watched metric of sequential comparison. That was good for an in-line performance, though, and Linear exited the quarter with a "slightly positive" book to bill ratio.

Margins also held few surprises. Gross margin was flat sequentially and up about a point from the year-ago level. Operating income rose 14% and declined about 3% sequentially, leading to an in-line result for income and a very slight beat on operating margin.

Good guide in a tricky quarter
Where Linear did please the Street was with its guidance. With management targeting 3% to 6% sequential growth in the next quarter, Linear is about 1% ahead of where the Street was. I will grant that 1% is not a huge beat, but the Street badly wants to see signs that analog chip companies are turning around. What's more, with Chinese New Year impacting the quarterly results, I would argue that there was more downside risk than upside potential in that guide.

Making a large commitment to two large markets
What excites me about Linear's prospects is the commitment that management has made to growing its industrial and auto businesses. There is no such thing as immunity from the cycle for an analog company of Linear's size, but applications like factory automation, process control, and autos (at the OEM level) do tend to be sticky due to the customers' risk aversion.

On the industrial side, Linear is looking to really leverage is 2012 acquisition of Dust Networks and its low-power wireless sensor network technology. These chips effectively allow machines to talk to each other and have transformative potential in the factory automation/process control space. Emerson has already designed them in as the "engine" of the company's wireless mesh sensor network and Dust could ultimately be the wellspring of a multi-hundred million dollar business for Linear.

To be sure, both Freescale and Analog Devices will look to get their own piece of the automation pie, and rivals like Siemens and Honeywell will develop competing approaches. Nevertheless, I think Linear's multiyear commitment to product development will pay substantial dividends in terms of incremental revenue and profit opportunities.

I likewise believe that the auto sector is a big opportunity for Linear. ON Semiconductor has a sizable presence here already, and Texas Instruments as been gaining ground with an attractive mix of chips with lower costs and increasingly higher performance. Even so, Linear is increasingly working directly with manufacturers like BMW and overall chip content in cars is increasing at around a 10% per year clip. With that, I believe autos could be over one-quarter of the company's sales in three to five years, and I expect applications in the powertrain, safety, and infotainment areas to offer solid margins.

How much growth is realistic?
The fly in the ointment is the already-high expectations investors have for Linear. Even if the company can accelerate its long-term revenue growth to around 6% a year (versus about 5% on a trailing 10-year basis) and maintain free cash flow margins in the low 40%'s, it's hard to get a DCF-based model to generate a fair value much above $42.

It's certainly true that growth markets in industrial could offer upside to that growth estimate, but I have to question just how much business is out there for the margins Linear demands. Likewise, I think Linear will have a hard time generate substantially higher free cash flow margins, given the limitations on revenue growth and the competitive behavior of rivals like Freescale, Analog Devices, and Texas Instruments.

The Bottom line
I've personally owned Linear profitably in the past and would love to do so again. Perhaps other analog chip companies will disappoint this quarter and lead to a sectorwide pullback. In any case, for Linear to appeal to me today I would either have to boost my expected long-term FCF growth rate to over 8% or be willing to accept below-market returns.

The Street does not typically use DCF-based methodologies to value Linear, so I don't doubt that the shares could keep going higher on "it's different this time" bullishness. I always favor investing with a margin of safety, though, so I'll be on the sidelines looking for a better entry price.

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